Darkest Before Dawn – Gaming Industry Waiting for Sunrise

It is always darkest before dawn, and right now the days are dark in the video game industry.

The industry is facing multiple challenges ranging from the migration of players from console games to digital online games; the growth of the iPhone and mobile devices as a free and discounted gaming platform; sky-rocketing development and marketing costs; and not to mention a consumer recession in which coughing up $50-$60 bucks a pop for a next generation platform game can be quite painful (read more on economy).

Recent console price cuts are a welcomed positive, but industry leading Electronic Arts CEO (Ticker: ERTS), John Riccitiello’s sober assessment of the industry was summarized as followed:

“While the recent hardware price reductions are driving higher console sales, the improvement is not enough to get the industry back to flat software sales for the calendar year. We now expect packaged goods software to be down mid-to-high single digits in North America and Europe combined. This is well below our initial expectations for the year.”

Not all is lost, however. I am amazed out how gaming has expanded since I was a kid. I may be dating myself, but I vividly recall the endless summer days of playing Adventure and Pac-Man on my Atari 2600 and heading over to the arcade to play Defender with my buddies. Since the 1970s, the industry has matured dramatically.

If you don’t believe me, check out the trailer from the new industry megahit Call of Duty: Modern Warfare 2. Industry analysts are calling for an amazing $500 million in sales…in the first week! By way of comparison, this year’s top-grossing film in the U.S., “Transformers: Revenge of the Fallen,” generated over $200 million in sales over the first five days of its release.

If you have more time to burn, you can take a walk down memory lane to look at the history of video games from 1972 to 2007.

Electronic Arts (ERTS) a Long-Term Winner

As the complexity of the video game industry rises, the barriers to entry become even tougher, and weaker competitors fall to the way side. Industry leaders like Electronic Arts (EA), with approximately $4 billion in revenues and $2 billion in cash and securities on their balance sheet (with virtually no debt), stand to be powerful survivors once the industry finds its way through the valley. Not a large percentage of companies have about a third of its market capitalization in cash. Financial strength alone does not mean much if a company were in continual decline, but I strongly believe the industry will eventually rebound and EA will be pulled up with the tide. In their most recent quarter, the company highlighted their growing market share in North America and Europe couple with their #1 software publisher positioning on the PlayStation3 (PS3) and Microsoft Xbox 360 platforms.

Given all the swirling shifts in the industry, EA is not sitting on its hands either. In conjunction with the company’s earnings release, EA simultaneously announced their acquisition of Playfish, the largest social networking game provider on the internet, attracting over 60 million players per month and securing the #2 game provider position on Facebook. On the cost front, the company is implementing a targeted headcount reduction by approximately 1,500 employees, which will reduce costs by at least $100 million. This austerity plan will make EA more competitive and allow the company to invest more in growth initiatives and better handle the curveballs thrown at them. EA has become more focused too. As part of the cuts, the company will reduce the number of game titles from the mid-60 count last year to the high-30s next year. Quality, not quantity is the new emphasis and more resources will be diverted to EA’s online digital efforts.

The traditional video game packaged-game industry is very hit-driven, much like the movie industry. One way EA deals with this challenge is by creating franchises that keep consumers wanting more, whether it’s sequels to the Sims, Harry Potter, or other titles. Better yet, EA has created a razor blade replacement model with their sports franchises. For example, in Electronic Art’s Madden NFL franchise football game, players need to update their athlete rosters to account for the annual post-season blockbuster trades and fresh rookie signees. EA’s Sports division has a built-in mechanism to drive recurring demand for new content.

With the stock over $60 less than 24 months ago, a large percentage of the industry and company warts have already been discovered and discounted into the current stock price (~$18). As with all my stock picks, I leave dry powder as ammunition for any future purchases at lower prices. The critical two week selling season has historically accounted for up to 1/3 of a company’s total annual sales – that’s what I call a back-end loaded revenue stream! Or put another way, the software industry traditionally generates almost half of its annual sales during the holiday season. The tightly concentrated timeline for sales may bring heightened volatility to the stock’s trading pattern in the coming weeks.

For those with an extended time horizon, one need only look at EA’s cash pile, market positioning, normalized earnings, and long-term industry prospects in order to take a closer examination at Electronic Arts. Times are dark in the video game industry, but dawn will be here soon enough and Electronic Arts is positioned to benefit when the time comes.

DISCLOSURE: Sidoxia Capital Management (SCM) and its clients have a long position in ERTS and AAPL at the time this article was originally posted. SCM and its clients own certain exchange traded funds, but currently have no direct position in ATVI, SNE, MSFT, or Facebook. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.